Is Financial Repression Here to Stay?

by Howard DaviesHoward Davies, former Chairman of Britain’s Financial Services Authority, Deputy Governor of the Bank of England, and Director of the London School of Economics, is a professor at Sciences Po in Paris.25.06.2015

LONDON – There are several definitions of financial repression – and the repressors and the repressed tend to see things differently. But what financial repression usually involves is keeping interest rates below their natural market level, to the benefit of borrowers at the expense of savers. The borrowers are often governments, and in many emerging economies the state has funded its extravagances by paying bank depositors derisory rates of interest.

But in the last seven years, since central banks in developed countries pushed down their base rates almost to zero, we have seen a First-World version of financial repression. A recent research report from the insurer Swiss Re describes who has won and lost as a result, and questions the sustainability of the policies pursued by institutions such as the United States Federal Reserve, the European Central Bank, and the Bank of England.

The report’s argument is that while the stated motivation for ultra-loose monetary policy might be to guard against deflation and promote economic growth at a time when demand is weak, low interest rates also help governments fund their debt very cheaply. Moreover, as we enter the eighth year of aggressive easing, unintended consequences are starting to appear – notably asset-price bubbles, increasing economic inequality (as wealthier investors able to hold equities benefit at the expense of small savers), and the risk of higher inflation in the future.

The jury may be out on the last point, but the first two are well established. Many countries now have over-heated property and equity markets; in the US, the S&P 500 index since 2009 has closely tracked the expansion of the Fed’s balance sheet. As a result, price-earnings (P/E) ratios, which reflect investors’ enthusiasm for equities, are now high by historical standards (Swiss Re has a Financial Market Excess index, which has returned to its 2007 level).

Moreover, according to the Swiss Re report, “monetary policy and central bank asset purchases have aggravated economic inequality via equity price inflation.” The top 1% of US households have enjoyed a 50% gain in their financial wealth, while the bottom 90% have registered only a 12% profit. The bottom 20% have probably not benefited at all.

Not surprisingly, central banks do not like this argument. Fed Chair Janet Yellen insists that years of near-zero interest rates and quantitative easing were not intended to make it easier for the US government to fund its deficit. She argues that focusing on asset prices ignores the role – helpful for all income groups – of the Fed’s monetary policy in maintaining growth and thus warding off the threat of a wholesale depression.

But central banks accept that their policies have led to distortions in financial markets. For example, institutional investors, especially insurance companies and pension funds, have suffered badly. They are major holders of fixed-interest securities, and their investment income has fallen sharply. The returns they can provide to investors and pensioners have similarly fallen. Logically, therefore, individuals need to save much more to guarantee their income in retirement.

That in itself may have a depressing effect on the economy, partly offsetting the monetary stimulus. Indeed, it may be one reason why highly expansionary policies by the Fed and other central banks have taken so long to generate growth.

A further distortion stems from the prudential regulation adopted in reaction to the global financial crisis. The imposition of higher capital requirements on riskier investments has pushed financial institutions into holding government debt, which in turn means that they have less money available to lend for productive investment. Most countries have yet to see investment recover to pre-crisis levels.

On this analysis, a return to “normal” interest rates cannot come soon enough. The alternative is further financial repression and, with it, low investment, rising economic and social tensions, and the emergence of a generation of impoverished pensioners. Like Monty Python’s city-terrorizing “Hell’s Grannies,” tomorrow’s elderly will surely make their voices heard.

But can we really expect the old normal – positive long-term interest rates on government bonds – to return? Maybe it is unreasonable for investors to expect positive rates on safe assets in the future. Perhaps we should expect to pay central banks and governments to keep our money safe, with positive returns offered only in return for some element of risk.

One reason is that investment may never reach its previous levels. If a service-based economy simply has less need for expensive fixed capital, why should we expect a return to the days when business investment was a strong component of demand? Apps are cheap.

Furthermore, excess savings could be more than just a cyclical phenomenon. Individuals may have come to value future consumption, in retirement, over current consumption – the reverse of the traditional relationship. We are beginning to appreciate that in our productive years we must work harder, because our retirement years will be longer and healthier, and the income support provided by our governments and employers will be far less generous than they used to be. In other words, it is rational to save more now.

In the long run, such a brave new world might not be an intolerable place. But the transition from here to there will be very challenging for financial firms, be they banks, asset managers or, particularly, insurers. The types of products that the latter offer to their customers will need to change, and the mix of assets in which they invest will be different, too. The question for regulators is whether, in responding to the financial crisis, they have created perverse incentives that are working against a recovery in long-term private-sector investment.

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